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Whilst there was no dispute (at first instance or in the Court of Appeal) as to the applicable principles of contractual interpretation, the Court of Appeal's judgment highlights that very different conclusions can be reached when applying those principles to complex transaction wording.

The appellants were subsidiaries of Lloyds Banking Group and Issuers of £8.3 billion of ECNs issued in December 2009. As at the date of the judgment, some £3.3 billion of the ECNs remained outstanding, with varying maturity dates from 2019 to 2032. Interest was payable on the outstanding ECNs at an average rate of 10.33% (equating to approximately £940,000 per day).

Pursuant to Conditions 8(e) and 19 of the ECNs, the Issuer could redeem the ECNs if a "Capital Disqualification Event" (or CDE) occurred. Condition 19 provided that:

"a [CDE] is deemed to have occurred […] if as a result of any changes to the Regulatory Capital Requirements or any change in the interpretation or application thereof by the FSA, the ECNs shall cease to be taken into account in whole or in part […] for the purposes of any "stress test" applied by the [PRA] in respect of the Consolidated Core Tier 1 Ratio"[1]

After the issue of the ECNs the regulatory regime changed, such that the FSA introduced the new regulatory concept of Common Equity Tier 1 capital (CET1 capital)[2].

The PRA conducted a "stress test" in December 2014 (the December 2014 Stress Test), in which the ECNs were not taken into account because Lloyds Banking Group met the new minimum capital thresholds without having to account for the ECNs.

Following the December 2014 Stress Test, the Issuers considered that a CDE had occurred, and sought to redeem the ECNs on that basis. The Trustee (on behalf of the Noteholders) sought a declaration as to whether a CDE had occurred.

The High Court's Conclusion

At first instance, the High Court held that the ECNs should be interpreted in the light of their admissible factual context so as to give effect to their objective commercial purpose. On a true construction of the ECNs, the ECNs had not ceased "to be taken into account for the purposes of any "stress test" applied by the PRA". The High Court held that Condition 19 should not be interpreted literally (requiring a stress test to be conducted solely by reference to the CT1 ratio at a fixed point in time) because it would produce an "extraordinary" result that could not have been intended. At the time that the ECNs were issued (in December 2009), the regulatory response to the financial crisis was still evolving, and the assumptions made by the regulator could and would involve an element of judgment about perceived economic risks and would change and evolve over time.

However, what the provision required (for a disqualification event) was for the ECNs to be disallowed in principle from stress testing by the regulator. That had not occurred, as the ECNs could still rank as CT1 capital.

The High Court declared that the Issuers were not entitled to redeem the ECNs and had to continue paying interest.

The Court of Appeal's Conclusion

The Issuers' appeal was unanimously allowed, with the leading judgment being given by Lady Justice Gloster.

The Court of Appeal was remarkably succinct in its summary of the principles of contractual interpretation applicable to the dispute, and helpfully laid those out in its judgment. There was also no dispute between the parties as to the applicable principles in relation to the construction of the ECNs (either at first instance, or before the Court of Appeal).

The Court of Appeal noted that these principles were "usefully summarised" in paragraphs 14 to 22 of the speech of Lord Neuberger in Arnold v Britton[3] and paragraphs 22 to 25 of Lord Hoffmann’s speech in Chartbrook Ltd v Persimmon Homes Ltd. The Court of Appeal quoted Lord Hoffmann at paragraph 25 of Chartbrook, where he had said:

“All that is required is that it should be clear that something has gone wrong with the language and that it should be clear what a reasonable person would have understood the parties to have meant.”

“[in complex documents of this kind] there are bound to be ambiguities, infelicities and inconsistencies. An over-literal interpretation of one provision without regard to the whole may distort or frustrate the commercial purpose.”

The Court held that it was clear that something had gone wrong with the language of Condition 19.

The words used in the definition of CDE (in particular the use of the words "any stress test") necessarily envisage that the stress testing carried out by the regulator would be a "dynamic process" and might change. As such, this aim and purpose would be undermined if a CDE happened only following a stress test that was carried out by reference to an historic or superseded capital ratio.

However, the High Court had been wrong to read into Condition 19 that a disqualification event only occurred where there was a "disallowance in principle". As a matter of language and purpose of the redemption provisions, the ECNs had ceased for the foreseeable future "to be taken into account … for the purposes of any "stress test" applied by a regulatory authority in respect of the [relevant ratio]".

Comment

Both the Court of Appeal and High Court rejected an over-literal interpretation of Condition 19 but reached different views on the commercial purpose of Condition 19 and the redemption mechanism, particularly in relation to the regulatory landscape and the way in which the parties had intended to account for that in the documentation. Despite the High Court and the Court of Appeal agreeing on the evolving nature of the regulatory framework, they disagreed on whether a CDE was triggered on that basis.

Lord Justice Briggs, who gave a short concurring judgment, noted that the question of construction was "really quite short", but "difficult", and one on which his mind had "vacillated several times".

This demonstrates that whilst the legal principles of contractual interpretation may now be settling (which is welcomed), it is clear that even "short" questions of construction still produce different – and costly – outcomes depending on a particular judge's view of the commercial purpose of a transaction.

From a practical and commercial point of view, the decision highlights the need for clear, unambiguous and forward-looking drafting.

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